Definition: A Certificate of Deposit (CD) is is a time deposit, which has a fixed term, such as 3-month, 6-month, one-year or 5-year maturities, and a fixed interest rate for the duration of the term. It is intended that the CD be held until maturity. The saver can receive interest during the stated term or they may receive the original deposit amount plus interest at the end of the term. The saver can also renew the CD at the same or a new fixed interest rate.
How to Use CDs for Saving
CDs are most commonly purchased at banks or credit unions. A saver can go to a local, physical bank location or they can search for the highest CD interest rates on Internet sites, such as Bankrate.com. CDs can be used for short-term savings goals, which are those with time horizons of less than 3 years. However, because CDs have stated time periods (maturities) the saver's money is tied up for the given period of time. If the saver withdraws money before the time period is up, they may be charged a fee. Therefore CDs should not be used as liquid savings, which is money you may need at any given moment, such as emergency funds, where a money market fund may be more appropriate.
When to Use (and When Not to Use) CDs
In the most simple of terms, people use CDs to grow their money. For this reason, CD savers need to pay close to inflation because, if you are not beating inflation over time, you are not growing your money!
There is a common misconception that CDs are "safe." This may be true in regard to their FDIC "guarantee." However, the biggest enemy of the saver (or fixed income investor) is inflation.
For example, the average historical rate of inflation is roughly 3.40%. Let's say you are feeling financially responsible and put your hard-earned cash into a CD, earning 2.00%, at the local bank. Doing some quick math, you can calculate the difference (2.00 - 3.40 = -1.40) and see that you are still losing to inflation by 1.40%. This doesn't even factor in the effect of taxes on your savings, which would reduce your real rate of interest (after inflation and taxes) even further! Therefore, in a low interest rate environment, you could save money in a CD but still value because of inflation and taxes -- you are doing what I call "losing money safely."
In summary, low interest rate environments are the worst time to use CDs, whereas high interest rate environments are the best. The conundrum here, however, is that interest rates are usually their lowest immediately following recessions, which is a time when savers and investors tend to avoid higher risk savings vehicles and investments.
When and How to Use CD Laddering Strategy
A CD laddering strategy is just as it sounds: A saver "builds" a ladder of CDs one rung at a time buy purchasing CDs consistently and periodically over a planned period of time.
The best time to use the CD ladder is when interest rates are low and are expected to rise in the near future. The timing and intervals of the ladder require a bit of planning. For example, if the saver believes interest rates will rise some time in the next year, and they have $10,000 to save, they may consider buying a 1-year, $1,000 CD every month for 10 months. Beginning in one year from the first CD purchase, the saver will have one CD maturing each month for 10 more months. The saver can then consider continuing the ladder by buying more CDs at higher rates.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.